A stable government would likely see a strengthening of the rupee while a third front-dominated government would push down the rupee.

The rupee, now enjoying a bout of relative stability against the dollar, may not command as much attention as the stock markets. Yet, over fairly long periods last year, the rupee’s extreme volatility was a matter of deep concern. Its precipitous fall at one stage, in September, amidst mounting current account deficit (CAD) threatened macro-economic stability. As is well known, the deft measures undertaken by the government and the Reserve Bank of India (RBI) helped in stabilising the rupee.

The regaining of overseas investors’ confidence is material to any discussion on the financial markets. More visible than any other financial market, the stock market has been reflecting the overseas investors’ confidence. As more and more capital flows come in from foreign institutional investors (FIIs), stock indices have been rising phenomenally.

The large dollar inflows are behind the rupee’s recovery. So large have these inflows been that the RBI has had to mop up a portion of the dollars to prevent a sharper rise in the rupee’s external value. That would hurt export competitiveness, badly needed today to keep the current account deficit in check. Not so long ago, the RBI was doing the reverse, selling dollars to support the falling rupee.

The important, if obvious, observation is that both stock market and the forex market have been moving in tandem. Stock indices have risen as FII’s pumped in large sums of money. The dollar inflows have been supporting the rupee.

In such a scenario, the results of the elections will test the commitment of these foreign institutional investors. Both the stock market and the forex market will be impacted by the results. In fact, in the run up to the elections, the stock markets have risen phenomenally on the belief that a “market-friendly” government will act “decisively”. Speculation is rife as to what will happen if the large expectations of the market are belied? What if the NDA is not able to form a government? Or even if it does it is only with the support of some difficult partners? Much has been written recently as to whether the new government, even if cohesive and free from internal bickerings, can really bring about the changes that investors think will happen?

To cut a long story short, the sentiment propping up the markets is not based on a sober assessment of election outcomes. There is scope for a further rise in the benchmark indices and the rupee. But just as easily the confidence might evaporate.

Forecasting a rupee-dollar exchange rate over the near-term is always a difficult proposition, more so during this election season. Most forecasters are hedging their bets — the rupee could trade in a wide range of say between Rs.55 and Rs.70 depending on how the results are perceived. A stable government would likely see a strengthening of the rupee while a third front-dominated government would push down the rupee.

Looking beyond election results, multiple factors will determine the rupee’s external value. An improvement in India’s economic fundamentals will be a positive factor. The gross domestic product (GDP) growth is expected to move up to above 6 per cent during the current year. The diminished outlook for agriculture consequent on a less than satisfactory monsoon forecast will be an inhibiting factor. Agriculture was a star performer last year.

Global factors obviously influence the rupee. Of specific interest to financial markets everywhere has been the U.S. Federal Reserve’s tapering programme. The winding down of the ultra-soft monetary policy will tighten the liquidity situation everywhere but India and other developing countries need to be particularly concerned. The flood of dollars that has driven up the markets cannot be taken for granted.

As the U.S. economy gains traction and interest rates rise, there will be a reverse flow of capital that had sought higher returns in India and other developing countries.

RBI Governor Rahuran Rajan’s repeated call for a synchronisation of monetary policies of the developed countries and developing ones is relevant even if it has not been heeded.

Both the forex and the stock markets are driven by similar considerations for now but over the medium-term the factors driving them may not be identical.